Moving Toward Cyclicals

This could be the year where we start to see the effects of all the easy money that's floating around begin to show up as creeping inflation, observes Kelley Wright of Investment Quality Trends.

The start of 2013 comes with welcome news for Investment Quality Trends; we were named to The Hulbert Financial Digest 2013 Newsletter Honor Roll. For inclusion in the Honor Roll, a newsletter must exhibit above-average performance in both up and down markets. That only 14 of the over 200 newsletters HFD follows meets these qualifications suggests this is an accomplishment worthy of distinction.

As we survey the current economic and market landscape in an attempt to divine the direction of both over the coming months and year, a few broad themes are easily discernible...but many more, however, are not.

What we know, for example, is that the Fed will remain accommodative and will continue to inject liquidity via outright bond purchases. This will keep Treasury yields low and dividend yields attractive. Real interest rates will also remain negative, which provides a bit of a floor beneath stock prices. In our view, this is a positive for financials.

There's also greater visibility as to how the federal debt and deficit issues will be addressed. While the numbers associated with both are not unimportant, the headline is what an increase in taxes and a reduction in spending represents: a sea change in fiscal policy thinking about the debt and deficits.

This is not to say that the federal government will embrace full-blown austerity; there isn’t the political will or the voter appetite for anything so radical. Nonetheless it is a change, albeit an incremental one, which inevitably will have ramifications in both the economy and the markets.

Contrary to much of the conventional wisdom, though, we don’t necessarily believe a change in tax and spending policy represents Armageddon for the markets. For one thing Washington doesn’t really cut spending; it simply reduces the rate of growth. Secondly, tax-policy changes are nothing new—just study a little history. The bottom line with both is that markets and investors will adjust.

This is not to suggest that there won’t be some bumps and bruises along the way, because there will be; you can’t change the direction of an aircraft carrier without some things sliding around on the deck. Be that as it may, it is important to remember that the economy is not the market and the market is not the economy.

Due to policy decisions and coordinated easing by central banks around the globe, economic and market fundamentals have effectively been trumped. What is clear, however, is each round of easing is losing its effectiveness, which suggests that the fundamentals will eventually assert and be affirmed. This is to say that inevitably there will be inflationary consequences for all of this coordinated easing.

The natural impulse when faced with economic and market uncertainty is to get defensive, which, admittedly, we have done over the last few years. Our thought going forward, however, is to look to the more cyclical areas of the market for both growth of capital and income.

To that end, we are focusing more on materials, industrials, and energy. We find excellent values in these areas, which is not to say there aren’t excellent values in the consumer discretionary, consumer staples and health care sectors. In somewhat colloquial terms, however, it would be fair to say we’ve rode those horses pretty hard. That being the case, it is time to diversify into other opportunities that are currently present and/or developing.

Central to our focus this year are payouts as a percentage of free cash flow, long-term histories of high return on equity, and the wherewithal to manage long-term debt to equity. By concentrating on these core metrics, we have confidence that these companies will not only withstand some tough sledding should it occur but also provide solid real total returns.